With interest rates near zero, the Fed must resort to quantitative easing to try to jump start the economy. For those who missed Econ 101, quantitative easing refers to increasing the money supply directly. This increases incomes, which theoretically enables and encourages consumers, who represent about 70% of the economy, to spend more.
However, this approach presents two drawbacks. First, by increasing the money supply, prices could rise quite quickly. However, with significant slack in demand and inventories building, this might not be a significant threat. The more significant drawback is the lack of investment that generally accompanies quantitative easing.
Conventional monetary policy focuses on lowering interest rates to increase demand. This reduces that cost for business investment and, therefore, increases business activity. Further, this investment in new products and processes drives the economy forward by fostering new efficiencies and creating new products. With quantitative easing, putting more money in circulation might make consumers feel wealthier in the short term. However, without the added kick from new products, and more efficient processes, prices will almost certainly rise.
Additionally, putting more money into the economy might not be very effective in the short run. Consumers’ reluctance to spend has manifested itself in rising savings rates, as a result of consumers’ realization that their balance sheets have suffered significant deterioration. In other words, consumers would likely use their new found “wealth” to pay down debt, or possibly save, in the likely event that the rate on their adjustable rate mortgages increases in the future, rather than spend. Therefore, it will take a significant increase in the money
supply to encourage consumption. This represents a ticking time bomb which could cause runaway inflation fairly soon.
As a die-hard liberal, I never thought I would say this, but targeted tax cuts which encourage investment in products that will enhance efficiency, create new jobs and enhance the country’s competitive position, represents a much more effective way to jump-start our ailing economy than the current Federal Reserve policy.
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